Portfolio Management【 Reading 59】Sample 2012, following

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Which of the following most accurately describes the appropriate position in credit default swaps and bonds? If an investor believes that credit risk is overstated by the market, the investor should:

A) buy a bond or sell a credit default swap.

B) sell a bond or sell a credit default swap.

C) sell a bond or buy a credit default swap.

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To gain an exposure to credit risk, an investor could buy a bond or sell a credit default swap. When the market realizes that a bond has less credit risk than thought, the bond will rise in price. Alternatively, by selling the swap, the investor would receive a premium up front and owe no further compensation to the swap buyer if in fact the bond does not experience a credit event.

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firm will potentially undergo a major financial restructuring where some of its debt may get downgraded. Which of the following positions would provide a bond investor protection against this event?

A) The fixed side of a plain vanilla interest rate swap.

B) The sale of a credit default swap.

C) The purchase of a credit default swap.

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A credit default swap becomes more valuable when the reference obligation (e.g. a bond) decreases in credit quality. The credit events that trigger compensation from a credit default swap are usually defined as bankruptcy, entity default, and restructuring. The purchase of the swap provides the buyer compensation if a credit event occurs. Plain vanilla interest rate swaps protect against market-wide interest rate risk but not credit risk.

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Which of the following is least accurate regarding credit default swaps?

A) The credit default swap market is highly regulated by government authorities.

B) Liquidity is usually greater in the credit default swap market than in the underlying cash market.

C) Short positions are more easily obtained using credit default swaps than shorting a bond.

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Credit default swaps are not highly regulated because they are confidential, over-the-counter contracts. Liquidity is often greater in the credit derivative market than it is in the underlying cash market.

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An investor would like to discreetly take a long position in a firm’s debt. Which of the following would be the most appropriate strategy?

A) The purchase of a bond.

B) The sale of a credit default swap.

C) The purchase of a credit default swap.

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If an investor believes the firm’s credit prospects are good and wishes to discreetly capitalize on this by taking a long position, the investor should sell a credit default swap. Credit derivatives are confidential, over-the-counter contracts. By selling the swap, the investor would receive a premium up front and owe no further compensation to the swap buyer if in fact the debt does not experience credit risk.

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An investor believes that a bond may temporarily increase in credit risk. Which of the following would be the most liquid method of exploiting this?

A) The sale of a credit default swap.

B) The purchase of a credit default swap.

C) The short sale of the bond.

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If an investor believes the firm’s credit prospects are poor in the near term and wishes to capitalize on this, the investor should buy a credit default swap. Although a short sale of a bond could accomplish the same objective, liquidity is often greater in the swap market than it is in the underlying cash market. The investor could pick a swap with a maturity similar to the expected time horizon of the credit risk. By buying the swap, the investor would receive compensation if the bond experiences an increase in credit risk.

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Which of the following entities is the fastest growing segment of the credit derivatives market?

A) Hedge funds.

B) Commercial banks.

C) Investment Banks.

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There are hedge funds that specialize in the trading of credit derivatives. In their pursuit of relative value opportunities, they have become quite active and are important providers of liquidity to the market. Hedge funds represent the fastest growing segment of the credit derivatives market.

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Which of the following is least likely a stated use of credit derivatives by commercial banks and corporations?

A) Income.

B) Speculation.

C) To satisfy regulatory standards.

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Commercial banks use credit derivatives to hedge their exposures and to satisfy regulators. Corporations use credit derivatives for hedging and income enhancement.

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Which of the following entities is the largest market participant in the credit derivatives market?

A) Hedge funds.

B) Commercial banks.

C) Investment Banks.

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Commercial banks use credit derivatives to hedge their exposures and to satisfy regulators. They are the largest participant in the market, with a share of 35-40%.

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Which of the following most accurately describes a basis trade using credit default swaps? The investor:

A) buys a long-term credit default swap and sells a short-term credit default swap.

B) exploits the difference between the credit default swap premium and asset swap spread.

C) buys a short-term credit default swap and sells a long-term credit default swap.

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In a basis trade, the credit default swap premium is compared to the asset swap spread of the underlying bond. The latter refers to a bond’s yield above a benchmark in a swap. This spread should reflect the credit risk of the bond. If it is higher than the credit default swap premium, the basis is negative and the investor would buy the bond and buy the credit default swap (buy protection against the long position), thereby creating an arbitrage opportunity.

invic

Which of the following most accurately describes a credit curve steepener trade using credit default swaps? The investor:

A) buys a short-term credit default swap and sells a long-term credit default swap.

B) sells a credit default swap on a firm’s subordinated debt and buys a cheaper credit default swap on the senior debt.

C) buys a long-term credit default swap and sells a short-term credit default swap.

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In a curve trade, an investor has different opinions about the long term versus short term prospects for a bond issuer. The trade can be a flattener or a steepener. In a credit curve steepener, the investor believes that the issuer has the ability to subsist in the short term, but that its long-term prospects are poor. The sale of the short-term credit default swap partially finances the purchase of the long-term credit default swap.